Emotions and Investing PC1324-Print

INVESTMENT STRATEGY

EMOTIONS AND INVESTING

Don’t Let Your Feelings Cloud Your Investment Decisions

Our emotions are part of our everyday lives. When it comes to finances, however, getting emotional tends to disrupt even the best planned investment strategies. Case in point: Emotions, and the behaviors they trigger, were part of the reason why individual investors underperformed the S&P 500 by nearly four percentage points, on average, over the past 20 years. 1 That’s because the desire to jump into a hot investment and to sell losers in order to avoid further losses tends to generate a pattern of buying high and selling low, according to behavioral

economist Richard Thaler, who teaches at the University of Chicago Booth School of Business. That mistake is what behavioral economists call overreaction. “And it’s not a particularly good strategy,” Thaler says. Missing out on returns can make it harder to meet your goals of saving for retirement, or setting aside money for your child(ren)’s education. Fortunately, being aware of your emotions and the common ways they can undermine your decisions about money can help limit the negative impacts on your long-term financial plans.

Emotional investing can lead investors to make irrational decisions that result in buying high and selling low.

COMMON EMOTIONAL INFLUENCES The following behavioral finance concepts reflect how emotions can have very real impacts on our ability to make the right financial decisions. Short-term thinking. Humans tend to discount future rewards compared to more immediate benefits. As a result, it is often hard to make long-term goals a priority in our everyday decisions. We can understand the importance of saving for retirement or a child’s college education, yet still find it hard not to splurge on a new car or relaxing vacation. Loss aversion . Short-term thinking becomes especially problematic when you consider another piece of behavioral finance wisdom: People tend to fear losses more than they value gains. This phenomenon, known as loss aversion, can lead investors to engage in risk-averse behavior that actually puts their investments in greater jeopardy. For example, our rational minds understand the markets will bounce back from a downswing, but our emotions lead us to overreact. “We think we will be smart enough to take the long view, but when markets actually drop we lose our courage and sell at the bottom,” says Thaler. Overconfidence. Studies have shown that the majority of investors consider themselves “above-average,” even though we can’t all be above-average. One study found that investors over-estimated their performance by as much as 11.5%